Foreign Investment, Growth, and Economic Freedom: What Is OPIC's Role?

About the Author

The particular question facing the Subcommittee today is whether
or not to reauthorize the Overseas Private Investment Corporation
(OPIC), presumably for another four years. OPIC's mission is "to
mobilize and facilitate the participation of United States private
capital and skills in the economic and social development of less
developed countries and areas, and countries in transition from
nonmarket to market economies."[1] The justification for the
OPIC mission is that in executing this investment mission, it
increases U.S. exports and therefore increases the number of U.S.
jobs.

While I find myself deeply supportive of the goals of OPIC, I am
not confident that the organization is actu­ally able to
achieve them. Ironically, OPIC was created in the late 1960s
because the traditional model of gov­ernment-to-government
funding of less developed economies was so clearly failing. In the
decades since, we continue to learn what strategies fail to promote
development, and there is a very dark cloud of failure over the
entire enterprise of pushing investment of any kind into economies,
rather than having economies compete to pull in investment dollars.
Likewise, the goals of job creation and export promotion seem to be
minor aspects of OPIC's mission, and there is no clear case that
the exports and jobs associated with OPIC are not at the expense of
efficiencies elsewhere.

Approaches to Economic Development
I should probably confess that while preparing for this testimony,
it dawned on me that OPIC is in a sense a competitor of mine. Our
project, the annual Index of Economic Freedom, has the
same goal that OPIC does, which is economic development.[2] But
our approaches are quite different. OPIC wants to push investments
into risky places by having the taxpayer offer risk insurance,
whereas I want governments aboard to first make their economies
competitive as a means to attract investment without any need for
U.S. taxpayer assistance.

In a time of massive budget deficits and unabated federal
spending, this would seem to be the perfect time to scrutinize the
necessity of OPIC. Any time Congress considers spending the money
of the American citizen, it should set a very, very high bar.

This is the standard which I use to evaluate con­gressional
spending and authorizations. Indeed, my colleague at the Heritage
Foundation, Dr. Edwin Feulner, provides clear guidelines in the
form of six questions that every government action or policy should
answer:

In order to justify continued funding, OPIC should be able to
make an airtight case in answering these questions.

How American Jobs Are Created
The notion that any government organization can "create" jobs is
not based on credible economic foundations. The private sector
creates jobs that last, whereas governments use taxed dollars to
pay for temporary work. Sometimes that work, such as construction
jobs that exist for a summer while a new road is laid, add value in
the form of a public good. That is, the externality of the
production of the job outweighs the cost of the worker's salary.
But it is not the inherent employment of the individual that is of
value. So the question is whether OPIC creates public value for the
U.S. taxpayer? Is it investing abroad in some fashion that
outweighs the fees that it charges to the U.S. government?

Investment Is a Consequence, Not a Cause of
Growth
The instinctive understanding of economic growth leads us to
believe that investment is a vital input because societies without
investment are obviously stagnant. We tend to see a link between
heavy levels of investment and economic growth. The appearance of
cranes and tractors in a bustling city is evidence. And yet, this
instinct is misguided. The question to ask is: Why are the cranes
and trac­tors here? Why in this city, not that city? Why this
country, not that country?

Rather than ask this question, our humanitarian urge is to
create new incentives to push investment into poor areas. But
pushing inputs is almost always ineffective, which reminds us of
the famous maxim "You cannot push a rope."

Growth economists have confirmed a strong cor­relation
between investment and economic growth. However, the use of
sophisticated time series econo­metrics has confirmed the
causality of the relation­ship. We know now that investment
does not cause growth, but vice versa. Countries that grow tend to
attract investment. This was a view first proposed, one might say,
by Adam Smith in the 18th century. It was articulated clearly in
the modern era by Albert Hirschman (a professor at Yale, Columbia,
Harvard, and the Institute for Advanced Study) in 1958.[4] But
current data have been able to confirm Hirschman's point that
growth causes investment, and the consensus of professional
economists is now resolved.

From an influential 1996 paper in the Quarterly Journal of
Economics, we learn:

"[O]bserved long-term relationships were due more to the effect
of growth on capital forma­tion than to the effect of capital
formation on growth";

"The main result persists when inter-country differences are
eliminated: growth seems to pre­cede capital formation";
and

"[I]informal and formal tests using only fixed investment
ratios as independent variables give evidence that economic growth
precedes capital formation, but no evidence that capital
formation precedes growth. Thus, the causality seems to run in
only one direction, from economic growth to capital formation."[5]

These authors used a technique known as Granger causality, named
after Nobel Prize recipient Clive Granger, who was also a professor
of mine at the University of California at San Diego in the late
1990s. I urge the Congress to consider the serious implications of
this research.

If we wish to combat poverty around the world, our efforts must
be geared toward promoting the institutions of growth first, not by
pushing invest­ments-and certainly not by reducing the costs of
bad risks.

This leads one to inquire about the nature of the "institutions
of growth"-those policies and cul­tures that create the
incentives for markets to form, for specialization to occur, and
for development to accelerate. Needless to say, the fruits of
economic development are born from private markets. Local and
national governments cannot plant the seeds of prosperity, but they
can create the climate for entre­preneurial seeds to
prosper.

In my next section, I will describe further the "institutions of
growth," which we have long attempted to understand and even
measure with our annual publication of the Index of Economic
Freedom.

Economic Freedom and the Institutions of
Growth
With the publication of the 2007 edition, The Heritage
Foundation/Wall Street Journal Index of Economic Freedom
marked its 13th anniversary. It was also my first year as director
and chief editor of the project. The idea of producing a
user-friendly "index of economic freedom" as a tool for
policy­makers and investors was first discussed at The
Her­itage Foundation in the late 1980s. The goal then, as it is
today, was to develop a systematic, empirical measurement of
economic freedom in countries throughout the world. I should
mention that we make all the material, country scores, and even raw
data available for free on the Internet at http://www.heritage.org/research/features/index/.

Economic theory dating back to the publication of Adam Smith's
The Wealth of Nations in 1776 emphasizes the lesson that
basic institutions that protect the liberty of individuals to
pursue their own economic interests result in greater prosperity
for the larger society. Modern scholars of political economy are
rediscovering the centrality of "free institutions" as fundamental
ingredients for rapid long-term growth. In other words, the
techniques may be new, but they reaffirm classic truths. The
objective of the Index is to catalogue those economic
institutions in a quantitative and rigorous manner.

Results from the Index of Economic
Freedom
The 2007 Index of Economic Freedom measures 157 countries
across 10 specific factors of economic freedom, which are:

Business Freedom

Trade Freedom

Fiscal Freedom

Freedom from Government

Monetary Freedom

Investment Freedom

Financial Freedom

Property Rights

Freedom from Corruption

Labor Freedom

High scores approaching 100 represent higher levels of freedom.
The higher the score on a factor, the lower the level of government
interference in the economy.

The methodology for measuring economic free­dom is
significantly upgraded. The new methodolo­gy uses a scale of
0-100 rather than the 1-5 brackets of previous years when assessing
the 10 component economic freedoms, which means that the new
overall scores are more refined and therefore more accurate.
Second, a new labor freedom factor has been added, and
entrepreneurship is being empha­sized in the business freedom
factor. Both of these new categories are based on data that became
avail­able from the World Bank only after 2004.

The methodology has been vetted and endorsed by a new academic
advisory board and should bet­ter reflect the details of each
country's economic policies. In order to compare country
performances from past years accurately, scores and rankings for
all previous years dating back to 1995 have been adjusted to
reflect the new methodology.

Economic freedom is strongly related to good economic
performance. The world's freest countries have twice the average
income of the second quin­tile of countries and over five times
the average income of the fifth quintile of countries. The freest
economies also have lower rates of unemployment and lower
inflation. These relationships hold across each quintile, meaning
that every quintile of less free economies has worse average rates
of inflation and unemployment than the preceding quintile has.

Progress is universal across all continents. Across the five
regions, Europe is clearly the most free using an unweighted
average (67.5 percent), fol­lowed at some distance by the
Americas (62.3 per­cent). The other three regions fall below
the world average: Asia-Pacific (59.1 percent), North Africa/
Middle East (57.2 percent), and sub-Saharan Africa (54.7 percent).
However, trends in freedom are mir­rored closely across all
regions. The main distin­guishing feature of the regions is
that Asia-Pacific countries have the highest variance, which means
that there is a much wider gap between the heights of freedom in
some economies and the lows in oth­ers that is nearly twice as
variable as the norm.

Of the 157 countries graded numerically in the 2007
Index, only seven have very high freedom scores of 80
percent or more, making them what we categorize as "free"
economies. Another 23 are in the 70 percent range, placing them in
the "mostly free" category. This means that less than one-fifth of
all countries have economic freedom scores higher than 70 percent.
The bulk of countries-107 econ­omies-have freedom scores of
50-70 percent. Half are "somewhat free" (scores of 60-70 percent),
and half are "mostly unfree" (scores of 50-60 percent). Only 20
countries have "repressed economies" with scores below 50
percent.

The typical country has an economy that is 60.6 percent free,
down slightly from 60.9 percent in 2006. These are the highest
scores ever recorded in the Index, so the overall trend
continues to be posi­tive. Among specific economies during the
past year, the scores of 65 countries are now higher, and the
scores of 92 countries are worse.

The variation in freedom among all of these coun­tries
declined again for the sixth year in a row, and the standard
deviation among scores now stands at 11.4, down one-tenth of a
percentage point from last year and down two full points since
1996.

There is a clear relationship between economic freedom and
numerous other cross-country vari­ables, the most prominent
being the strong relation­ship between the level of freedom and
the level of prosperity in a given country. Previous editions of
the Index have confirmed the tangible benefits of
liv­ing in freer societies. Not only is a higher level of
economic freedom clearly associated with a higher level of per
capita gross domestic product (GDP), but those higher GDP growth
rates seem to create a virtuous cycle, triggering further
improvements in economic freedom. This can most clearly be
under­stood with the observation that a ten point increase in
economic freedom corresponds to a doubling of income per
capita.

The reason that I am devoting so much of my tes­timony
to the topic of economic freedom is because I hope to impress on
you the centrality of internally generated policy change as the key
to development. To be blunt, countries control their own fate, and
it is almost always impossible for external forces to "jump start
economic growth.

Is OPIC Necessary?
I do not believe there is justification to reautho­rize OPIC.
It pains me to say that, because I share the objectives of the good
people who work at OPIC. But as designed, I think it is clear that
the organization is based on an outdated economic philosophical
foundation. I would like to make a number of minor points.

First, is OPIC really costless to the taxpayer? It claims to be
a net economic gain for the U.S., in the sense that it is
generating revenue. But how does it generate income? Having
scrutinized some of the balance sheets for OPIC, my eyes are drawn
to Statement of Income on page 41 of its annual report. Of $403
million in 2006 revenues, nearly half come from fees.[6] But
who is paying those fees? I may be wrong, but I assume those fees
are paid by the U.S. government for services rendered. Perhaps this
would be a fruitful line of inquiry for the Sub­committee to
pursue.

Second, if OPIC is a profitable enterprise, then why does it
need re-authorization from Congress? In that case, I would
recommend that Congress sell it off and take the proceeds of that
"IPO" to pay down the deficit, while letting OPIC continue its
mission as a private entity. If instead, the accounting numbers
show that on net OPIC is not truly profit­able, but that its
costs are creating some public good that is worth it, then we can
at least have an honest discussion.

Third, the only merit I can see for the existence of OPIC would
be if its investments were geared toward promotion of economic
freedom, particu­larly in places of strategic interest for U.S.
foreign policy. What I would hope is that OPIC would not be
reinforcing nations that are economically unfree.

Again turning to OPIC's annual report, I was sur­prised to
see how little OPIC money has been geared towards the economic
development of Iraq. Com­pare the $200 million being spent on
Russia by OPIC to the $6 million spent on Iraq. Barely $1 million
was spent on Afghanistan. The mismatch of funds to national
priorities is astounding. In contrast, $19 million was spent
on projects in Vietnam. But why Vietnam? Yes, they are a vital
partner for the U.S., but they are also one of the hottest
economies in all of Asia, and a hotbed for private market
investments.

Let's face it: If your global mutual fund isn't allo­cating
some dollars into Vietnam, you should be upset. Why then, does the
U.S. taxpayer need to spend its precious strategic dollars in
Vietnam instead of Afghanistan? Is economic development in
Afghanistan only 6 percent as important as it is in Vietnam? Is
economic progress in Iraq only one-third as important as as it is
in Vietnam?

To be fair, and in order to provide some intellec­tual rigor
to this inquiry, let's consider a broader view. In preparation for
today's hearing, I assembled the data on OPIC's recent investments
into various countries and compared it to the economic freedom
scores those countries received in our 2007 Index of Economic
Freedom.

There are 39 countries that received OPIC finance or insurance
that also received a score in our Index. Keep in mind that
a score below 50 percent is consid­ered a repressed economy.
The average score world­wide in 2007 was 60.6 percent. What I
found was that the average freedom score of countries receiving
OPIC funds was 58 percent. Further, I calculate a weighted average
so that countries with higher fund­ing levels are counted
proportionally more; the weighted average freedom score of
countries receiving OPIC funds was 59 percent. Frankly, this is an
encouraging finding, as it shows that very few OPIC dollars are
supporting investments in unfree econo­mies. In fact, more than
half of OPIC dollars are spent in support of investments in what
The Heritage Foun­dation categorizes as free economies.

As my earlier points must reveal, this finding does not lead me
to conclude that OPIC should be reauthorized, but it is somewhat
heartening.

Conclusion
Realistically, I have come to accept the maxim of Ronald Reagan
that once a government program is created, it is practically
immortal. But I do feel strongly that OPIC should be revised, with
a cap on the fees that it can charge to the U.S. taxpayer-and I
would suggest cutting these in half.

In light of all the evidence, however, my recom­mendation
would be that Congress explore a phase-out of OPIC. Its operations
are duplicative of the private sector, generally, and the funding
of activi­ties of high value for U.S. foreign policy are
clearly not a priority in light of the levels of funding towards
Iraq and Afghanistan. It is difficult for me to understand why,
then, the organization exists, which is what the great Milton
Friedman cautioned years ago when he said, "I cannot see any
redeeming aspect in the existence of OPIC."

Tim Kane, Ph.D., is
Director of the Center for International Trade and Economics at The
Heritage Foundation. These remarks were delivered May 24, 2007,
before the U.S. House Committee on Foreign Affairs, Subcommittee on
Terrorism, Nonproliferation, and Trade.